Definition: Underapplied overhead occurs when the estimated overhead applied during the period is less than the actual overhead incurred during the period. In other words, not even overhead was booked in the original estimate.
What Does Under Applied Overhead Mean?
During the course of the year many businesses choose to budget and project future expenses. This helps management plan for cash flows throughout the year as well as establish goals. One expense that is often projected into the future periods is overhead. Many businesses book estimated overhead amounts every week or month to evaluate the profitability for the period.
Even though overhead doesn’t affect cash flows, it still shows up in the bottom line or net income. Most managers want to be able to show a profit even after overhead expense, so an estimated amount of overhead is applied for each period. The problem is sometimes the estimated overhead applied is not always right.
Take a machine shop for example. The machine shop estimates that its overhead will be $1,000 a month for next three months. It books overhead expense for $1,000 at the beginning of each month. After the quarter has ended, it turns out that total overhead incurred for the last three months was $3,600—not $3,000. Now the machine shop has to book an additional $600 of overhead expense because the original estimate what under applied.
Overapplied overhead works the same way. If the company booked $4,000 of estimated overhead at the beginning of the quarter, it would have to reverse the overapplied overhead, so estimated overhead booked matches the actual overhead incurred for the period.